Tuesday, September 30, 2008

Friend of the blog Jeff Alworth posed a challenge in the comments: can you explain what's at stake in the credit crisis for the average "person on the street." I started to write a response but it quickly turned into the now well-worn "credit dries up, housing market gets even worse, recession, unemployment, etc." and realized that I wasn't really helping. So I am going to try a new tack: explaining in simple terms (sorry, econ majors, bear with me) why credit matters so much to the economy.

So let's start with the observation that healthy economies keep money circulating - the more it moves around the more it can be put to productive uses. Consider the simple, stylized example that often starts a money and banking course. A person saving for retirement wants to make sure there will be enough money available to them to live on in the future. So they start to stockpile cash in their mattress. At the same time, someone else has a great idea for a new business, one that could make a time saving device for all to benefit from and that would employ many people in its manufacture. Problem is, this person does not have enough money to start making the devices but knows that if she could borrow it, her business would be successful enough to repay it many times over. Could each person be made better off than the current stalemate of money in the mattress and insufficient funds to make the time-saving device? Of course! The saver could end up with more money to live on in retirement if they could loan it with interest and the borrower would happily pay interest in order to see her business get off the ground. [NB: We economists call this a Pareto improving exchange as both parties are made better off and no one is worse off]

The problem is of course that the saver may never know the borrower exists, so even though they both would like to make this exchange, they cannot. This is where banks and other financial intermediaries come in, they help facilitate the exchange. In fact, banks simply offer interest if you deposit money with them, they don't make you wait to be paired up with a borrower. They go out and look for borrowers and charge them a higher rate than they pay to borrowers and the difference is how they make money. And why not, it is a valuable service to both parties. It is also a valuable service to society because now lots of entrepreneurs can find money to start up new businesses and these businesses employ workers, pay taxes and potentially make life better for the consumers of their products.

But we still haven't left Bedford Falls where the building and loan collects locals deposits and lends them out as mortgages. Now let's move to the bigger world of banking finance. In the modern banking system banks on a daily basis have surpluses and shortages as money flows rapidly and hundreds of thousands of deposits and loans are accounted for. The money that comes from savers now comes from around the world and is loaned out around the worlds too, though much of the worlds savings has been spent, recently, by US consumers. To keep all of this money flowing to its most productive uses, banks regularly borrow and lend from and to each other. And just like us little people, they too pay and charge interest rates. And the problem right now is that this lending has essentially seized up, leaving banks high and dry when they are trying to raise some liquidity to lend in order to make some money to counter the quickly sinking assets they have on their balance sheet (largely mortgage backed securities). Without this ability to raise capital, banks are in danger of collapsing (e.g. WaMu). To see for yourself, look at the TED spread which is the difference in a measure of bank-to-bank interest rates and the rate in the T-Bill. If you are a bank with some excess capital on your books and you want to earn money rather than having that money in your mattress (so to speak) you can invest it in the safest instrument around (the T-Bill) or you can lend it to another bank. This second option is not as safe because there is a higher probability that you might not get paid back, and thus bank-to-bank interest rates are always a little bit higher - until now. Now they have gone through the roof. This is the purest snapshot of the trouble the credit market is in at the moment.

So it all maters to you. In the wide world of banking, these intermediaries are like the fuel pump to an economy, constantly pumping the fuel (credit or other people's savings) to where it is most combustible, to the most productive uses. By so doing, it really keeps the engine of the economy running, it keeps existing businesses going, new businesses starting and consumers able to consume. So credit really is the fuel for the engine of an economy. In my work as a development economist, we often finger the credit markets (or lack thereof) as a major obstacle to growth in low income countries.

What I would expect the 'person in the street' to see, if banks are allowed to fail is a drying up of credit for things like houses, education and consumer loans. I expect to see a spike in unemployment, a further and perhaps much more dramatic fall in the residential housing market and a significant slowing of economic growth and probably negative growth for some time. This all hurts. Tax revenues will suffer, so state services will be diminished. Jobs will be harder to come by and the ability to smooth consumption spending will be curtailed by the lack of credit.

So it is not the big CEOs of these banks that will suffer if the banking system is allowed to collapse (they are incredibly wealthy already, they'll be fine), but the most vulnerable in society that will suffer. I, for one, hope the bill is passed very soon.

Incidentally, my big concern is if $700 Billion is enough. I think that the probability that the US will take a big loss on these assets goes down the bigger is the bailout. That's because the US is hoping that this temporary hysteria in the credit market is what has collapsed the price of these mortgage backed securities, not that they really are worthless. The likelihood that these will return to a reasonable price is greater the greater is the bailout (the healthier the banks become and the more money is put back into housing - the fundamental asset behind these securities).

For the last week or so, I have been following the comments on the bailout/rescue plan on BlueOregon and Oregon Catalyst, which reflect local left/right thinking. The comments have been running 10/1 against. And, presumably, this has something to do with the negative votes of the majority of the folks in our congressional delegation. However, most of the comments just don’t make sense. They remind me of Howard Beale standing up during the middle of his newscast crying, "I'm as mad as Hell, and I'm not going to take this anymore!"

The Paulson Plan is quite simple. Both the Fed and the Treasury see the immediate problem as one of monetary contraction. As the value of bank assets drop, so too does their ability to extend credit. Why is the value of their assets dropping? No one knows what they are worth, so they aren’t worth much. Buyers won’t sell; sellers won’t buy except at extremely distressed prices.

If the immediate problem is preventing monetary contraction, the solution is to buck up bank balance sheets. That can be done by swapping T-Bills for the commercial. Moreover, if the Treasury makes the swaps by reverse auction they will also jump-start the market for the assets not offered for sale. It should work.

What are the disadvantages of this plan (all plans have disadvantages – there are no free lunches)? One is stressed by libertarian monetary theorists like many of the 200 signers of the economists’ petition against the bailout: the monetary /banking system is prone to excess, because it is so interconnected, politically responsive (corrupt), and debt dependent. We ought to let the market sort things out. If it takes a depression, so be it. We’ll be better off as a result. This view has some merit, but I’d prefer not to run the risk.

On the other hand, folks like Paul Krugman want to go even further than Treasury. Rather than relying on open market operations, something the Treasury knows how to do. They want the Treasury to take an equity position in failing banks as the Swedes have or Treasury did with Fanny-Mae and Freddy-Mac. This would minimize the risk to the public fisc, but probably also deter private investors from making investments in this sector.

The Paulson plan does not rule out this option, but neither does it require it. It is a sensible, prudent middle-of-the-road proposal.

In the mean time, three cheers for Darlene Hooley. It is nice to be represented by an adult.

Friday, September 26, 2008

Editor's Note: A thousand thanks to Fred Thompson and his contributions to this blog during a time when I have been unable to provide much content. Fred promises to take a breather for a while and, based on this contribution especially, I hope he doesn't really mean it. For what it is worth, I think this post pretty accurately describes mine and many other economists preference for extra-market transfers in lieu of market distorting taxes and rigidities (see: my rants abut the prohibition on self-service gas). Take it away Fred...__________________________________________________________Last week, at Blue Oregon, Chuck Shekatoff of the Oregon Center for Public Policy (OCPP) accused the communications and lobbying firm ConklingFiskum & McCormick (CFM) of slipping into “into Political BS (Bogus Statement) mode. The CFMarticle asserted ‘[h]owever, for the majority of that time [since 2002] the state unemployment rate has remained higher than the national average.’ The suggestion by CFM and business groups that a relatively high minimum wage and higher-than-average unemployment levels are related is Political BS.”

Shekatoff asserts that Oregon’s typically higher-than-national-average unemployment is due to population growth and the structure of our economy and cites an OCPP report and economists at the Oregon Employment Department in support of this claim. When, however, one checks the OCPP report (Who’s Getting Ahead) the evidence cited is short discussion of the issues by an Oregon Employment Department economist, Art Ayre, “Why Does Oregon Have a High Unemployment Rate?” published April 27, 2005. This is, indeed, a very nice discussion of the issues. It correctly observes that “economists usually speak of unemployment as having three components: frictional, cyclical, and structural. All three contribute to Oregon's higher-than-national rate.” However, while it is clear that Ayre has a keen grasp of the issues and the Oregon labor market. The evidentiary basis for his claims is simply not reported.

Indeed, it is hard to see how two of the factors he cites, the structure of the economy and population growth could explain Oregon’s RELATIVE unemployment when compared with the rest of the United States. The structure of Oregon’s economy is essentially a constant. It is axiomatic that a variable that doesn’t vary cannot explain any variance, although it might explain the intercept in an empirical model (which is how I understand Ayre’s claim, although I would stress that ‘might’ leaves a powerful lot of wiggle room). But if you take population growth as the independent variable in an empirical model and relative unemployment (or employment growth) as the dependent variable, one actually obtains a negative relationship. Now I don’t believe for a moment that population growth really causes unemployment to fall (or employment to grow). My hunch is that the causal arrow goes in the opposite direction.

The main driver of unemployment in Oregon is America’s business cycle. America’s booms and busts are also Oregon’s. But what explains Oregon’s RELATIVE unemployment. As a classroom exercise, I have had my students look at this issue several times over the past decade or so, using monthly data, the difference in unemployment (or employment growth) between Oregon and the US as the dependent variable and anything they could think of as independent (or causal) variables. The two variables that seem to explain Oregon’s relative unemployment best are the dollar’s exchange rate with other currencies and the state government's stop and start spending behavior.

The fact is that Oregon industry and agriculture are highly affected by foreign trade. When the dollar is low, they do well, at least so long as the rest of the world isn't in the tank. When it is high, they don't. This is a structural factor that varies measurably over time. Moreover, the state relies on a highly progressive tax structure. Progressive taxes are necessarily volatile revenue sources. Revenue volatility encourages spending volatility, making our booms and busts bigger than elsewhere. This is a cyclical factor unique to Oregon.

Early this year, I took a spreadsheet from the work of one of my better students and tossed a dummy variable representing Oregon’s adoption of a premium minimum wage into her model. The effect was statistically significant, as was the increase in the adjusted coefficient of determination. However, from the standpoint of relative unemployment (or the relative change in total employment), the negative effect was very small. This isn’t a very good test. It’s not a good econometric model. Moreover, using the change in Oregon’s minimum wage relative to the national average would have been better. But when I did the analysis, I lacked that data. Nevertheless, I think its results are likely to be correct. Oregon’s high minimum wage almost certainly makes relative unemployment worse, but the effect is probably not very big, at least not compared to other significant factors.

The reason I believe this is because it is consistent with what most other economists, who have looked closely and carefully at this issue, have found. My reading of contemporary research that the effect of high minimum wages on low-income employment is far more likely to be negative than neutral. Of course, employers can increase prices. But, other things equal, increased prices mean lower sales volume and fewer employees (otherwise, presumably, those employers would have already raised prices). High minimum wages also lead to rationing inefficiencies, which are probably more important than the job losses, but that is another story. One can recognize that high minimum wages have adverse effects and still support minimum wages, even high minimum wages. The consensus among labor economists is that minimum wages help many more low-wage workers than they hurt.

But its supporters shouldn't fool themselves that its effects are entirely benign. If anything is political BS, that is.

Obama proposes to raise the national minimum wage to $9.50 per hour in 2011 and index it to inflation. He also wants to increase the Earned Income Tax Credit (EITC) for working Americans with no children and for those with three or more children and a tax credit of up to $500 per person or $1,000 per couple. This would be a rebate of the worker’s Social Security contribution on the first $8,100 of earnings. Like the EITC, this helps low-income working families without creating employment disincentives.

Most economists believe that we could get more equality at a lower cost by focusing on bottom-end personal income tax brackets and expanding the EITC than by raising minimum wages. Consequently, I’d prefer it if Obama were less enthusiastic about increasing minimum wages and more committed to across-the-board increases in the EITC. Here in Oregon, one thing that we could do is to eliminate the first two brackets of the state personal income tax. Failing the better, however, we should probably, as Chuck Shekatoffproposes, celebrate the pretty good.

Disclosure, Gary Conkling of FSM is my colleague at the Atkinson Graduate School of Management.

Well here is a local (sort-of) take on the credit crisis: a major retail bank (i.e. not just a Wall Street investment bank) fails. Wa Mu which expanded like nuts and was investing in mortgages and mortgage backed assets found itself in big trouble with the subprime mess and the collapse of the residential housing market. Seems like only yesterday that they were the darlings of the banking industry.

This is, folks, an unprecedented shake out of the banking industry, and yes you should worry. The Paulson Plan may not be perfect, but doing nothing is not an option.

Wednesday, September 24, 2008

Life is too crazy. Perhaps the most momentous economic news of my lifetime and I am struggling to find time to blog about it. I am moving, painting, starting a new academic year. ..what is a poor blogger to do?

In this case punt to the radio show, OPB's Think Out Loud, I was a guest on this morning. Click here to listen.

While I may be shirking, there is no dearth of stuff in the blog-o-sphere about this. Mark Thoma is always a good place to start.

Sunday, September 21, 2008

In my last blog I suggested that tax shifting caused by the 1986 federal tax reform act accounts for two well-noted recent phenomena: the increasing concentration of personal income and the declining rates of corporate profitability. At the federal level, this means that households in the top percentile of the income distribution, especially "small business" owners (a majority of the folks in this income group), pay more federal income taxes than they once would have, a lot less corporate income taxes, and, consequently, end up with a whole lot more money in their pockets.

What the feds did also affected state-level fiscal outcomes in Oregon. Because Oregon’s statutory tax rates were unchanged at 6.6 percent for corporations and 9 percent for individuals, tax shifting in response to changes in the federal tax code probably caused the owners of its 6,000 or so biggest small businesses to increase their personal income tax payments by more than they reduced their corporate income tax payments. This is probably the main reason Oregon’s corporate income tax revenues have dropped relative to its personal income tax revenues, as has happened all over the country.

Of course, the state corporate income tax hits big publicly owned corporations as well as smaller closely held corporations. The reported profits of big publicly owned corporations have boomed in recent decades. But, while they must pay state income taxes somewhere, they aren’t paying higher corporate income taxes in Oregon. The reason for this is somewhat counterintuitive. Corporations that operate in several states can often find ways to have their income taxed in low-tax states rather than in high-tax states. And, if they can, they do, and have for years. Oregon’s statutory corporate income tax rate is among the highest in the US and this has long given big corporations an incentive to go tax shopping.

There’s more: we recently made tax shopping easier for big businesses. Once, the proportion of a firm’s profits that Oregon taxed depended the average of its employees, its assets, and its final sales located within the state relative to the total number of its employees, assets, and final sales. Now we look only at sales. This approach works fairly well for retailers, hotel and restaurant chains, utilities, and the like. But it allows most other big corporations, especially those selling goods and services to other businesses, to pay state taxes wherever they want to and that’s not here. This is the second reason for the drop in Oregon’s corporate income tax revenues relative to its personal income tax revenues: we have sent the revenues to other states.

So, if what we want is to increase Oregon’s tax take, why don’t we just cut the corporate income tax rate and go back to the old tripartite system of tax apportionment? (To be frank, it is by no means clear to me that Oregon’s revenues are inadequate. True, the state has had to borrow $3-4 billion to deal with revenue shortfalls. But over the last two business cycles (1994-present) the state has also rebated $6-7 billion to personal and corporate income taxpayers.)

Lane Shetterly’s Revenue Restructuring Task Force seems to want to increase Oregon’s tax take or, at least, its potential to do so. They have looked at a variety of tax swaps intended to do lots of things, but the one big thing they seem to be working toward is increasing the state’s capacity to raise revenue when it is needed.

Here, I want to look at their most attractive option: swapping the state’s corporate income tax for a transactions tax. To draw precise conclusions about the benefits and costs of a transactions tax one would need to look closely at the details of its administration. Nevertheless, one can make some broad claims about transactions taxes in general with reasonable accuracy.

First, transactions taxes are no more paid by businesses than are corporate income taxes. People pay taxes. The important question is, "which people?" (Economists refer to this as tax incidence question.)

Who bears the burden of Oregon’s corporate income tax? The owners, mostly.Who would bear the burden of a transactions tax? Customers, ultimately consumers, mostly.

A transactions tax is basically a tax on receipts or sales. Indeed, if the only entities covered were suppliers selling to consumers, then a transactions tax would be identical to a retail sales tax. If it included all goods and service providers regardless of their customers, as in Washington State, for example, it would still probably be like a sales tax in its incidence, but it would have several perverse consequences. For example, it would provide an incentive to businesses to buy their supplies from out of state firms and encourage vertical integration of supply chains. However, these effects would likely be insignificant as long as the transaction-tax rate remained low.

So, as a first approximation, this swap would increase revenues a little bit by shifting taxes from mostly rich owners to mostly not rich consumers.One could maintain the overall progressivity of Oregon’s tax structure by simultaneously increasing the top bracket of the state’s personal income tax from 9 percent to about 9.5 percent and dropping the bottom two brackets altogether (full disclosure: I think this is a good idea, in any case). But as noted above, one can get an almost identical result to that contemplated by the tax swap plus the change in personal income rates merely by cutting the state’s corporate tax rate to ≥ 5 percent and reverting to the old system of apportionment. Why do something difficult and complicated when something far easier and much simpler will suffice?

What my discussion to this point omits is the option value of a transactions tax. Increasing state income tax revenues is not easy now; it will be practically impossible in the future when the federal government increases personal income and payroll tax rates. Establishing a well-designed transactions tax would, therefore, give the state the potential capacity (or option) to:

· Generate large amounts of revenue.· Extract payment from individuals with high capacity to pay taxes, but low current income, including those successfully evading the personal income tax, and· Diversify the revenue base (reduce the volatility of the state revenue stream).

All of these things imply tax rates that would be high enough to bite, however. In that case, the perverse incentives associated with a gross receipts tax would become a serious matter.

The conclusion I draw from this is that, if the balancing factor is the transactions tax’s option value, we ought to adopt a design that would avoid its perverse effects, if that option were struck and the program expanded. That is, the tax should apply only to the increment in value contributed by tax unit at each stage in the process of production, distribution, and delivery, so that an entity’s taxable transactions would be equal to the difference between its sales or gross receipts and its purchases of inputs from other entities, i.e., the tax unit’s earnings before interest, depreciation, and taxes, plus employee compensation.….By the way, we call what I have described a value-added tax.

Thursday, September 18, 2008

Okay, so this is starting to get a little scary. What do the government agencies charged with overseeing the economy do when investors all get spooked and start to panic en masse? For a while the twin attacks of propping up major financial institutions and injecting liquidity seemed to be working, but something spooked the horses again and they are all racing for the stables:

This is the three month treasury bill rate chart. When there is strong demand for treasuries the price goes up (meaning the rates fall). Look at what has happened in the last few days. As treasuries are just about the safest investment available this represents a tremendous "flight to safety" among the major financial actors.

Another measure of how spooked they are is the TED spread which is essentially the difference between what banks charge each other for loans and these safe investments (3 month treasuries). Banks charge each other more when they feel the risk has increased and risk increases when other banks become less likely to repay these loans (like Lehman Brothers). Well here is what happened to the TED spread in the last few days:

What happens when the newly fluid, integrated and worldwide financial markets get so incredibly spooked all at once? Nobody knows. That is why I am getting a little spooked myself. Still, I remain optimistic that things will stabilize soon (I said that two months ago as well, so...) and slowly the credit market will start functioning more normally. Why do I say this? Well remember that flights to safety are good, short-term, cover your arse strategies, but the essential business of banking is lending money to make money. They can't long survive without getting their capital out there working again. At least that's the theory.

Update, I try to avoid cross-posting, the purpose of this blog not being to provide a comprehensive conduit to the entire world of economics news and opinion (Mark Thoma has the lock on this but also does not, apparently, sleep) but this is too good to pass up: over at the Freakonomics Blog at the NY Times, there is a great synopsis of recent events.

Wednesday, September 17, 2008

Editor's Note: Once again Fred Thompson rescues this over-burdened blogger with an interesting and detailed discussion of tax policy and income inequality.

The most conclusive evidence showing that that families within the top 1 percent of the income distribution experienced very large gains relative to the average since 1980 comes from Piketty-Saez, who use tax data to construct their inequality estimates.

Piketty-Saez further show that much of the increased concentration of personal income occurred between 1986 and 1988. They accept that much of that increase was a consequence of the 1986 Tax Reform Act, which reduced the difference between personal tax rates and corporate tax rates, thereby causing a shift of income to the personal tax base from the corporate tax base. Indeed, they acknowledge that tax shifting could easily account for two well-noted phenomena of recent decades: the increasing concentration of personal income and the declining rates of corporate profitability. Nevertheless, they argue that if that tax reform was all that was going on then the upper-percentile income share would have shrunk down to its 1986 level over the following decade and, needless to say, the share did not.

However, I think Piketty-Saez are wrong in assuming that shift in income from corporations to individuals caused by the 1986 TRA was a one shot deal. In the first place, corporate profitability (based on the federal flow of funds accounts) dropped significantly in 1982 and in 1986 and has subsequently continued its downward trend, despite the fact that America’s biggest firms earned record profits during this period. Where did the missing income go? Many tax experts believe that much of what is now reported as personal income was previously reported as corporate income.

Not only did the 1986 TRA reduce the difference between personal tax rates and corporate tax rates, it also made it easier for the owners of S corporations and most professional corporations to treat profit from their businesses as personal rather than corporate income and arguably increased the incentives of the owners of closely-held C corporations to treat corporate income as personal income, in part by severely restricting the use of tax shelters and requiring businesses to treat most benefits they provided in-kind to their owners as ordinary personal income (even funds deposited by these businesses in tax-deferred retirement accounts, a sum of $17 trillion in 2007, are now counted as personal income when earned, where once they were treated as a business expense until they were distributed). Consequently, the number of S and professional corporations shot up after 1986 and has continued to grow at a steady rate as a percentage of all corporations in the US ever since.

A lot, maybe most, of the discussion of high earning individuals is misleading. It focuses on the CEOs of big corporations, sports stars, and entertainers. But those folks represent a tiny proportion of the 1 million-plus families in the top 1 percent of the income distribution. Most high-income families have high incomes because they own businesses, farms, or legal, medical, or financial service providers. For example, it has been estimated that the CEOs of the 500 biggest corporations in American and the 500 highest paid athletes and entertainers earn about $25 million on average. That adds up to $25 billion. In contrast, it looks like the 570,000 small-business owners in the top 1 percent of the income distribution may have shifted $300 billion from their corporate accounts to their personal accounts in 1995 more than they would have if the 1986 TRA had never been enacted into law. This implies that they paid about $40-$50 billion more income tax that year than otherwise, but, perhaps, as much as $100 billion less in corporate income taxes, maybe more.

In other words, what the 1986 TRA allowed them to do was keep a lot more of what they earned. Consequently, the effects of the 1986 TRA were reflected in reduced corporate incomes, which in turn reduced corporate income tax payments. Of course, this is not the only reason for declining corporate income tax payments, especially at the state level, but it is probably the main reason. The effects of the 1986 TRA were also reflected in higher reported personal incomes and, despite reductions in marginal rates, increases in personal income tax payments.

This last fact accounts for the claim that Laffer was right, tax rate cuts produced increased government revenue. However, that claim ignores the effect on corporate income tax revenues. Almost no serious student of public finance believes that, tax rate cuts produce increased government revenue at current rates, or is even close to being true.

On the other hand, every serious student of public finance knows that taxes create wedges and most accept that dead-weight losses increase as an exponential function of marginal tax rates. The interesting question is how much of the relative increase in the income reported by Piketty-Saez is due to income shifting, how much is due to reduced corporate tax payments, and how much is due to a reduction in the tax wedge.

The Tax Foundation got blasted for suggesting that the answer to the last part of this question is 20-40 percent. Those do not seem like completely unrealistic numbers to me. Moreover, that is probably also the upper limit of the real increase in the gains in pre-tax income accruing to the top 1 percent of the income distribution relative to the average.

Figure 2. Tax Wedges on Labor Income Showing How an Increase in Tax Rates can Reduce Revenues by Increasing Deadweight Losses

It is a striking fact that the fraction of total wealth held by the rich has not changed noticeably in the last 70-80 years. As Saez observes” “A jump in reported wage income with no change in wealth is consistent with the income-shifting explanation, since all that is changing is where income is reported, not how much income is earned.” We could say the same thing about the consumption of families in the top 1 percent of the income distribution, although this may be an artifact of the methods the census bureau uses to survey consumption levels.

These issues may seem more relevant to federal tax policy than to state tax policy and, indeed, most of the discussion about them is in that context. But Oregon is currently addressing some fundamental issues about its tax structure that reflect the issues addressed here. One prominent proposal involves substituting a transaction tax (probably like a sales tax in its incidence) for the existing state corporate income tax (which this argument suggests is much more like the personal income tax in its). This analysis goes directly to an assessment of the likely consequences, both in terms of adequacy and fairness, of those alternatives, especially given the kinds of changes to federal income taxes we can anticipate under either Obama or McCain.

Tuesday, September 16, 2008

There are tons of crazy and interesting things going in the world of Wall Street - hopefully I can blog about it in more detail soon - and yet here I am blogging instead about a pet peeve. So, it is time to pick on The Oregonian. Once again, they have reported on median sales price data and in both the headline and the article that say something along the lines of "the average Portland house has lost $22,000 in value." (The new and improved OregonLive site does not seem to have a trace of the article and my copy of the paper was too efficiently recycled so I am going by memory) No, no and an thousand times no. These data tell you nothing of the sort. You absolutely cannot say that house values have depreciated. They may have, or not. These data tell you only transaction prices, it could be simply that a greater proportion of smaller, less expensive houses sold. So, for the last time, Oregonian, stop it!

Much of my free time is being spent in my new 100 year old house trying to do some work before we move in so my blogging has been sporadic - terrible timing with all of the interesting things going on - but I will try to get more out soon, starting with an interesting piece by friend of the blog Fred Thompson. In addition to the regular junk I post, I hope soon to start blogging regularly on the economic aspects of local, state and national elections.

Wednesday, September 10, 2008

On Monday, The Oregonian had another article about the success of Major league Soccer in the US. And while the article was fine, by focusing on past and current demand I think it missed an essential aspect of investing in a business - expected future returns. MLS has made major strides in its short history: there is now a steady roster of teams, many new soccer-specific stadiums, more wealthy owners and an increasing talent pool. But these are only partly why franchise fees have gone from $10 to $40 million in a few short years. The fundamental trajectory of soccer, the world's most popular sport, in the world's biggest market is clear: up, up, up.

This is different than saying 'everyone else in the world loves soccer, so should the US,' this is about the fact that the soccer crazy world spends a lot of money following soccer and watches it rabidly. Top European soccer teams are as valuable as the biggest NFL and MLB clubs in America and English teams are falling over themselves to try and get a piece of the US market. So there are huge potential returns globally from the growth of the MLS. It is probably decades away, but that does not stop current valuations from reflecting the potential future returns. There is a reason, on other words, that Merritt Paulson is going to put up the 40 million himself - he does not want to share the potentially huge payday if franchise fees continue appreciating they way they have been recently.

Even domestically, there are many reasons to expect that attendance and viewership will keep increasing. The US population is increasingly representative of cultures where soccer is the main sport. The growth in soccer participation among youth players has been explosive whcih not only increases the potential domestic talent pool, but creates generations of soccer-savvy fans.

As for Portland, the proven support for professional soccer and a stadium that could become the best soccer stadium in the country make it a pretty safe bet for the city, one would think.

In short, the future returns from a professional soccer club in America are potentially huge. Merritt Paulson is no idiot. He is not about to spend $40 million on a suckers bet.

So my field experiment is over. My wife and I are the proud owners of a new house in SE Portland. My experience with the market has been quite interesting. There is still a lot of buyers out there and good (remodeled, move-in ready) properties were going for over asking after bidding wars. But may fixers, more marginal houses and overprices houses are sitting. We were after a fixer and we got one after we waited for an over-priced one to sit and made a fairly low (but quite fair in my opinion) offer that was accepted. So, my interpretation of the market is that the market has changed significantly,but sellers have been slow to adjust their expectations. Two years ago it was the more marginal properties that were going for above asking price.

As for the mortgage market, we had no problem securing financing, but were were required to provide full documentation and they would not qualify my wife until she had a couple of months pay stubs from her new employer (a contract was insufficient). I don't think there is much sub-prime financing out there at all, so all of those buyers are not active currently. This is perhaps why marginal properties are not being bought to flip.

We got a rate that in historical perspective is quite good, but nothing like two years ago. I was fine with this, I understand the credit markets and accept the outcome. But it does kinda sting when, on the day of closing mortgage rates plummet on news of the Fannie and Freddie bailouts. What galls me is this: it has been clear that the federal government was going to do this for weeks, so why didn't markets already price this into mortgages? This is a picture of the rates crash that also represents that sinking feeling in my stomach.

Finally, one curious anecdote. I was talking to a contractor that does a lot of little jobs, and whom I might employ to do a few things at my new house, and he was telling me he has never been busier than he is right now. This is counterintuitive given the difficulty of obtaining home equity lines of credit and the like. But it could just be that his reputation for excellent work is spreading.

Thursday, September 4, 2008

The Oregonian reports today on Merritt Paulson's request that the city borrow $75 million on the bond market to pay for renovations to PGE Park and to build a new Beavers stadium in Lents so that he can buy an MLS franchise and bring it to Portland. The obvious economic question is: is this a good idea for the City of Portland?

[A quick disclaimer, I have played soccer all my life, am a devoted fan of the sport (and pretty good judge of teams - see my amazingly insightful prediction of Spanish success in the European Championship in June) and personally would welcome an MLS team in Portland.]

There has been quite a bit of economic research on the effects of new stadia and new teams and the results are in general agreement that there is little measurable net positive impact of teams and stadia to overall investment or economic activity. This research has done a lot to change the public debate about such projects, ten years ago, you would probably have heard about stadia being economic engines driving the city forward. Now, there is little in the way of overblown promises about being a boon to overall economic activity and, I think, Paulson and the City of Portland are to be commended in keeping the rhetoric subdued: with reasonable patronage, the teams could service the debt. Portland would carry the risk and the reward is an MLS team and a nicer place to watch baseball.

Though overall investment and economic activity are not seen to be increased by stadia construction, there is some agreement that such projects can serve as focal points for investment. In other words they can attract investment to an area that might not otherwise see it. This comes form the fact that there are positive externalities that comes from gathering people together in new or improved stadia: you bring custom to areas that would not normally see it. This custom is not totally captured by the teams themselves and thus there is a positive benefit that can be captured by those interested in opening up shops, restaurants, bars and even new housing.

Anecdotally, Denver is a good example of this. Before Coors field, Lower Downtown in Denver was a run-down warehouse district, with the new ball park it is now a thriving entertainment and shopping district and many, many new apartment projects have sprung up around the park advertising their proximity to the park and the district. [A caveat: we will never know the counter-factual - would LoDo have had the same renaissance without the stadium? This problem plagues economic research and we do the best we can to try and deal with it, but all of this evidence on the impact of stadiums is, at best, strongly suggestive.]

So, while there does not seem to be evidence of overall increases in economic activity (e.g., we should not expect the Portland tax revenue to increase), it is reasonable to talk about creating a focal point for local investment. Whether the small minor-league park envisioned for Lents is enough to drive enough investment to really create a change in the area is an open question, but I suspect so (it will also, hopefully, be small enough to avoid the other side of the externality: noise, trash and traffic). Open to debate, however, is whether there is another way to create a self-funded way to create a focal point (e.g., BIDs).

So is it a good idea? Well, people derive happiness from having sports and cultural attractions (we often see survey evidence of such attractions being a prime reason people choose to live where they do) but it is a very hard thing to measure. The point is that the benefits of having sports teams is more than just the measurable economic activity that they create, but the utility people derive from their presence. Whether it is worth the risk to the City of Portland to finance the stadium projects ultimately depends on how much these sporting attractions matter to Portland residents.

The Oregonian also published today an Op-Ed piece that argued that the City should not invest in stadia but rather green jobs. In it the author points out, rightly, that there is no evidence of overall net increases in economic activity or tax revenues from such investments, but wrongly suggests that we should, therefore, expect no local investment in Lents. These two things are not the same. What is worse is that the author presents a false dichotomy: invest the $75 million in energy improvements for housing. I have nothing against such a proposal in principle - but it has very little to do with the sports stadium proposal. The $75 million for stadia is intended to be self-funded, the green housing proposal is not self-funded. The fact that the city would borrow $75 million could impact their ability to raise more funds as cheaply in the future, but should not prevent them from investing in green housing or other such proposals in any significant way.

Tuesday, September 2, 2008

My conversion to Apple is now virtually complete - I have been seduced by the iPhone 3G. Now I am one of the uber-hip cognoscenti that gets to ridicule Microsoft and can find the nearest pizza, listen to the latest uber-hip music and check my e-mail at the same time. (I think I can even call somebody if I want - but I'm not sure). Yes, I know, the battery is weak, the 3G network is weak, etc., but that is entirely missing the point - it is sooo cool (and no the fact that I purchased one is not evidence of the early onset of midlife crisis as my wife claims).

But the fact that I am now cool is not what I wanted to write about. What is interesting about the iPhone is that in the US it is a part of a pair with the AT&T wireless network and the utility that I derive from the iPhone depends not only on how well Apple designed it, but also how good AT&T has made their network. This creates something interesting in economics - strategic complements (in, in this case, quality). This term refers to the fact that if Apple makes a better iPhone, AT&T has the incentive to make a better network and vice-versa. Why, because each product is more valuable to consumers the better is the other thing. However, there is a catch: though AT&T could get people to pay more if they were to make their network better, they would not capture all of the increase in peoples willingness to pay, some would probably be caught by Apple (and, again, vice-versa). So this makes Apple and AT&T a bit uncomfortable bedfellows - they are both interested in similar things (selling as many phones and combined service contracts) - but they are ultimately interested only in increasing the values of their stock.

Thus it comes as no surprise to read in the New York Times recently that Apple and AT&Ts iPhone service is perhaps not quite as good as it should be and that each company probably wishes the other would do just a bit better. Is there a solution? Yes, Apple and AT&T could merge and become a single company. Then incentives would be perfectly aligned and we should expect both better phones and a better network. Another way is to get create separate markets for phones and networks (i.e., to require unlocked phones). This is the way it works for the most part in Europe, I am told. It is true that there is still the strategic complements aspect, but with stiff quality competition in each market, we should expect an efficient outcome there. Imagine...an iPhone on Verizon's network - now that would be cool!

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This blog seeks to comment on economic issues that matter to the state of Oregon. These issues may be local, state or national but in some way matter to Oregon and Oregonians. The goal of this blog is to eschew politics as much as possible and give an economist's perspective on economics and public policy as it relates to Oregon.

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